This article was written by Brent Bates, a senior portfolio manager with the Invesco International Growth team, focusing on large- and mid-cap Asia Pacific and Latin American equities.
Emerging market economies continued a downward trend during the second quarter, with declining industrial production and weak auto and retail sales. While there were a couple of positives, emerging markets confronted an otherwise disheartening litany of negatives, both external and domestic.
- Externally, lower commodity prices created major headwinds for the many commodity-producing economies. Coupled with soft exports, weak commodity prices have made emerging markets vulnerable to increased current account deficits. Weak currencies are leading to higher inflation and interest rates. Domestic economies haven’t been robust enough to offset weakness in commodities and exports.
- Overall emerging market gross domestic product (GDP) revisions were negative for the quarter, driven by export decline and weak domestic consumption. Overcapacity, deleveraging and uncertain government fiscal positions have weakened confidence domestically, causing a slowdown in consumption and investment.
A bright spot: In contrast, many Asian countries, which are net oil importers, benefitted from lower commodity prices. Inflation is also decreasing, allowing more leeway to cut interest rates, which we’ve seen in China, Korea, India and Thailand this year.
Despite glimmers of stabilization during the quarter, the corporate earnings revision ratio remained the worst globally.1 The main drivers to the downside were the commodity cycle, weak currency, tight lending conditions and China’s slowdown, all continuing risks that could lead to more disappointing earnings.
Attractive valuations were a positive — emerging markets’ trailing price-to-book ratio (P/B) traded at a 20% discount to its historical average and at a 35% discount to the developed world.2 More good news:
With raw materials and labor input cost pressures easing, operating margins were more resilient than typically expected when revenue pressure exists.
Not surprisingly, investment opportunities have been scattershot rather than broad based. Let’s look at second-quarter snapshots of several emerging market economies.
China: Sleuthing the slowdown for stocks
The economy continued to show clear signs of a further slowdown, sending ripple effects throughout the region. Weak domestic consumption has failed thus far to offset China’s de-emphasis on its investment- and export-driven economy. Despite the headwinds, we see positives going forward, including:
- Many of China’s problems are easier to resolve than issues facing some emerging markets, in our view.
- Excess capacity is being worked off with capital expenditure cuts and continued economic growth.
- China is benefitting from weaker commodity prices.
- Balance sheets of Chinese consumers are solid with low leverage, creating capacity to spend.
- Inflation rates are low, and the government has many levers at its disposal to maintain liquidity.
With a very expensive valuation and leverage a significant driver, China’s domestic A share market was a bubble waiting for a justified correction. But we believe the recent turmoil shouldn’t have a significant impact on the economy, given that the equity market accounted for a small portion of household wealth and equity funding is a small part of total corporate financing. Although we haven’t owned A shares, there are some very good businesses we would be happy to own at the right valuations.
The A share market gyrations and resulting correction in domestic Asian markets also brought down the valuation of the Hong Kong-listed H shares market — H shares’ P/B ratio traded at an attractive 30% discount to its historical average and at a 35% discount to the developed world.2 We took this opportunity to add to our position in H share stock WH Group (1.64% and 1.61% of Invesco Developing Markets Fund and Invesco Asia Pacific Growth Fund, respectively, as of June 30, 2015), a top domestic brand and the world’s largest producer of packaged pork products that generates nearly half its operating profit from its US Smithfield business.3 Despite this resilience, the stock sold off tremendously in sympathy with the A share market, enabling us obtain it at less than 9x earnings.
As disconcerting as volatility may be, we believe it tends to create long-term benefits for our shareholders. It’s rare to find a thriving business at a compelling valuation when everything is going right; those valuations occur when fear dominates the market.
Brazil: Holdings sound, despite bad news
Brazil’s announced fiscal budget cut raised concerns about the government’s ability to stabilize debt and fueled speculation about a rating agency downgrade to below investment grade. Meanwhile, currency depreciated further, unemployment rose, the recession deepened, and the inflation continued higher. Despite the negatives, we remain focused on fundamentals — and we haven’t seen any structural impairment to the competitive advantages of the businesses whose stock we own.
India: Positive headlines, high valuations
We’re often asked why we haven’t invested significantly in India, one of the few places in our purview where headlines are positive. There’s an interesting contrast between India and the rest of Asia. For India, sentiment is positive, growth expectations are high and investors tend to be overweight toward India versus other Asian nations. Valuations have been higher on only two occasions over the past 20 years — in 1999 and 2000 before the technology bubble burst in 2007, and also in 2008, just before the Great Recession.1